A summary of Frank’s argument is in order. He claims that many of the goods we buy are “positional.” In other words, their value to those who own them depends strongly on relative position rather than anything absolute. Frank gives the example of a Ferrari Scaglietti, a car that sells in the United States for about $250,000. According to Frank, purchases of such cars and of 60,000-square-foot houses “subtly change the social frame of reference that defines what kinds of houses and cars seem necessary or appropriate.” The people who buy such things up the ante on their purchases, and then the people “below” them do likewise, and so on down the income scale. Frank calls this alleged phenomenon an “expenditure cascade.” In buying positional goods, the highest‐income people, writes Frank, impose a negative externality on the people below them, who then, through their purchases, impose a negative externality on those below them, and so on. Frank advocates the standard economist’s solution to a negative externality, which is a tax on the activity that generates the externality. Frank’s favored tax is a tax on consumption, with a higher rate for those who consume more.
As a bonus, argues Frank, a government can tax high‐income people even more than it currently does without making them worse off. How so? For simplicity, imagine a society in which there are a million people making more than $500,000 a year. Most of us would agree, I think, that those people have high incomes. Imagine that they now pay 30 percent of their income in federal income taxes. Now imagine that the government, following Frank’s suggestion, imposes a tax on consumption above some amount per year and, thus, raises tax rates on high‐income people so that those million people now pay 40 percent of their income in federal income taxes. Because their relative position with respect to each other would be unchanged, and because they spend so much money on positional goods anyway, they would not care — or so the argument goes. As Frank testified, “Thus, if a consumption tax led wealthy families to buy 5,000-square-foot houses instead [of] 8,000, and Porsche Boxsters instead of Ferraris, no one would really be worse off, and several hundred thousand dollars of resources per family would be freed up for more pressing purposes.” The government could then take the extra revenue generated by the higher tax rates and spend it on things that people, including many of those with high incomes, value. Because the added tax has a zero cost to those taxed and the revenues create benefits for at least some members of society, the tax creates net benefits. That is, in a nutshell, Frank’s argument for higher taxes on people with high incomes.
Frank adopts Fred Hirsch’s characterization of positional goods: “goods that are sought after less because of any absolute property they possess than because they compare favorably with others in their class.” Frank also writes, “Positional goods are, by their nature, things in fixed supply.” He gives houses, cars, and jobs as examples of positional goods and medical care and leisure as examples of nonpositional goods. And yet, his examples seem to belie his definition. While it’s true that certain jobs — chairman of Microsoft, for example — are in fixed supply, houses and cars are not. And yet, in Frank’s mind, they’re positional. Leisure, on the other hand, if it involves courtside seats at a New York Knicks game, seems to involve fixed supply: the number of such seats is strictly limited. Given how important positional goods are to Frank’s whole scheme, it’s surprising how he doesn’t seem to follow his own definition in classifying goods one way or the other while still seeming to be quite confident about which is which.
Ignoring the Changing Evidence
A pillar of Frank’s argument is that a large percentage of people care about their relative position. In Choosing the Right Pond, he defends that assumption by pointing to anomalies in the pay structure of various firms, anomalies that he attributes to people caring about relative position. Most of his anomalies have to do with pay structures that, Frank argues, are “flatter” than standard economics would predict. Standard economics states that workers are paid an amount roughly equal to the value of their marginal product — that is, the increment in value that is due to their being in the firm. But, notes Frank, if this were true, one would expect to see great disparities between the salaries of workers who have great differences in productivity. He points to, among other things, the University of Michigan pay scale for economists in 1983–84, where the highest salary was only a little more than double the lowest. He never mentions the fact that the University of Michigan is a government bureaucracy, making it not the best test of the standard economics account of freemarket wages. Nor does he mention that one of the main ways the stars of academic institutions are “paid” is with lower teaching loads and more research funds.
Even more interesting is how the world seems to have changed since Frank began writing about these issues and the contortions he goes through to sustain his argument for higher taxes. When he first began, he argued that relatively flat pay structures are indirect evidence for his view that people care a lot about relative position. But in his May 2007 testimony, Frank noted that the “anti‐raiding norms of business have recently begun to unravel” so that, now, pay for top managers can be a huge multiple of pay for bottom managers. In other words, it would seem, many top managers are being paid an amount that approximates their marginal product. You might think that this would cause Frank to reexamine his earlier strongly held views. But he doesn’t.
Instead, he comes up with a new argument for progressive consumption taxes. He now argues that too many people are vying for the top jobs because of the higher pay those jobs carry. They are fighting, he argues, over a fixed pie and, in a variant of the famous “tragedy of the commons,” he compares the competition for the top jobs to gold prospecting. He testified that “the gold found by a newcomer to a crowded gold field is largely gold that would otherwise have been found by others.” Similarly, he argues, “an increase in the number of aspiring hedge fund managers produces much less than a proportional increase in the amount of commissions on managed investments.”
But he can’t hold on to this argument for even a page. Just four paragraphs later, he testified: “A slightly more talented CEO or hedge fund manager can boost a large organization’s annual bottom line by hundreds of millions of dollars or more.” Exactly. It does make sense, therefore, for companies to look for small differences in talent because those differences can cause huge increases in profits. The problem with Frank’s tragedy of the commons analogy is that there is no commons. The tragedy of the commons occurs when no one owns the resource: thus the word “commons.” But those who hire hedgefund managers own their resources, so one would not expect overinvestment in being the manager. Frank implicitly admits this, writing, “To be sure, even those who fail to win the biggest prizes often go on to earn comfortable incomes.” But in the very next sentence, he retreats to his old position, saying, “But career choices must be measured not in terms of absolute pay but relative to what might have been” (emphasis added). This is astounding. More than 20 years ago, Frank argued, as an empirical matter, that people care about relative income. Now in the face of evidence that absolute income matters a lot to them — otherwise, why would anti‐raiding norms have unraveled — he argues that it shouldn’t — thus his use of the word “must.” If the people don’t conform to his assumptions, it seems, we should tell them to.
I may have interpreted Frank’s use of the word “must” incorrectly because he goes on to write, “Contestants for the top prizes in finance are highly talented people who could have held interesting jobs at high pay in other fields. Those who end up as account managers in small banks may not starve, but neither do they realize their full potential.” Frank’s argument here, presumably, is that people overestimate their expected return from competing for superstar jobs and so they overinvest in competing for them. “Overinvest” is determined relative to a baseline of efficient allocation of people to jobs. This is what we “must” compare the actual outcome to. But this is incredibly presumptuous on his part. Does Frank really think tax policy ought to encourage would‐be novelists to go to medical school? He writes as if the world is a place of certainty and he heavily discounts the extent to which competition is a discovery process.
Taxes, Work, and GDP
Interesting also is how Frank deals with the supply‐side economists’ argument that higher marginal tax rates reduce effort, and how his argument has evolved. In Choosing the Right Pond, Frank accepted the view that higher marginal tax rates do, indeed, reduce work effort — and applauded that result. Frank wrote:
The real problem is not at all that the current tax system induces people to work too little, take too few risks, and so on. On the contrary, it is a lack of taxation that would cause individually rational citizens to work too many hours, take too many risks, and spend too little time with family and friends (emphasis in original).
By the time his 1999 book, Luxury Fever, was published and in his 2007 testimony, though, Frank had changed his argument. Interestingly, while he correctly used the term “supply‐sider” in his 1985 book, by 1999 he no longer used that term; instead he used the disparaging term “trickle‐down theory” to label the supply‐side theory that changes in marginal tax rates affect economic behavior. (No supply‐sider calls himself a trickle‐down theorist: this is the term used exclusively by critics of supplyside economists. Frank’s use of the term “trickle‐down” suggests bad faith on his part.) Interestingly, Frank now argues that marginal tax rates do not clearly reduce work effort and briefly dismisses the substantial evidence that supply‐side economists such as Harvard’s Martin Feldstein have presented. Nowhere could I find Frank acknowledging this complete reversal of his 1985 argument. Was he wrong then or is he wrong now?
Furthermore, in arguing for a progressive consumption tax, Frank contradicts another big part of his earlier work without ever acknowledging it: he argues that a progressive consumption tax will increase GDP. That is doubtful, but let’s accept it for a minute. Why is this good? I know why I think it’s good: GDP is a rough measure of human welfare. Of course, there are huge problems with GDP as a measure of welfare, two of the most important being GDP’s failure to value leisure time and its valuing of government expenditures at cost. But we can put those aside because they do not relate to Frank’s argument. Why does Frank think GDP is a good measure of welfare? After all, he has spent a large part of the quarter century arguing that it is not a good measure. In Luxury Fever, he recalls his time in the Peace Corps in Nepal: